Over the past three years, Japan’s stock market has responded very positively to the government’s efforts to kick-start its long moribund economy. Thanks to aggressive monetary easing, which started in 2013, the Japanese yen has fallen about 30% against the U.S. dollar. A weaker yen has been a boon for Japanese exporters, who have since been reporting stronger earnings growth. And as these export-oriented electronics and consumer firms continue to rally on improving earnings, financial firms have been able to reap higher profits from a stock market boom. Over the past three years, the Nikkei 225 benchmark has returned 120% (in yen), significantly outperforming the S&P 500, which gained 60% in U.S. dollar terms, over the same time period.
Investors in Japanese equities have benefited from these trends over the past few years, but a weakening currency is certainly not a sustainable solution for longer-term corporate earnings growth. Looking forward, the government is trying to address some long-standing issues that have weighed on the country’s growth potential—namely, corporate Japan’s indifference to building shareholder value. Japan’s returns on equity have historically been about half that of the S&P 500 for a few key reasons. First, Japanese firms tend to hold an excess of rainy-day cash, an asset that generates almost no returns. Second, Japanese firms have a legacy of crossholdings, under which weak companies are kept afloat by their parent company. These practices are well entrenched in corporate Japan and are supported by an insular and staid corporate governance environment where directors are loath to push for change.
The Japanese government has launched a number of initiatives to try to bring Japan’s corporate governance practices to be more in line with global standards. In 2014, the government unveiled its Stewardship Code, a set of guidelines for how institutional investors can more effectively engage with company management to focus on medium- and long-term growth. The following year, the government addressed the issue on the corporate side with the launch of the Corporate Governance Code, which pushes for better transparency and more independent board members.
The Nikkei 400 Index
To highlight companies doing right by shareholders, a new equity benchmark comprised of “good” companies was created in 2014. This benchmark, the Nikkei 400 Index, screens for 400 companies that have the highest returns on equity and operating profits. Bonus points are given to firms who have appointed outside directors, have adopted (or plan to adopt) international financial reporting standards, and provide financial statements in English. Index constituents are first weighted by float-adjusted market capitalization, but then the index applies a 1.5% weighting cap on individual holdings. To help give this index some influence over corporate Japan, the government has encouraged the Government Pension Investment Fund, the world’s largest pension program, to invest in companies included in the Nikkei 400 Index rather than the Nikkei 225 Index or the TOPIX, the more common benchmarks for Japanese equities. The Bank of Japan is also buying Nikkei 400 exchange-traded funds as part of its effort to support Japan’s capital markets. In Japan, about 20 index funds tracking the Nikkei 400 Index launched in 2014. Since launching, these funds have gathered almost $6 billion in assets.
Why should investors care about this new benchmark? In theory, the “good” companies of the Nikkei 400 Index would exhibit better long-term performance, making a Nikkei 400 ETF an attractive investment choice for Japanese equity exposure.
Actually, the trailing three- and five-year performance of the Nikkei 400 Index has been 100% correlated to that of the MSCI Japan Index, the market-cap weighted benchmark underlying iShares MSCI Japan (EWJ), the largest Japan equity fund listed in the United States. This is because the constituents of the two indexes are almost the same. The only difference of note is the 1.5% cap on the weighting of the Nikkei 400 Index’s individual constituents (which is reset at the annual rebalance). The MSCI Japan Index does not have similar weighting caps and therefore has a few large holdings (such as Toyota and Mitsubishi UFJ Financial) whose performance can have a larger impact on the MSCI Japan Index relative to the Nikkei 400 Index. On the other hand, the Nikkei 400 and the Nikkei 225 indexes have been 97% correlated over the past three and five years. This slightly lower correlation can be partly explained by the fact that the Nikkei 225 is a price-weighted index, so there are more notable differences in the weightings of individual constituents between the Nikkei 225 and the Nikkei 400 indexes. This is evident in the table below, which shows the relative weightings of the top five components of the MSCI Japan Index and the Nikkei 225 Index versus the new Nikkei 400 benchmark.
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Taking the Long View
While the Nikkei 400 Index will ostensibly identify the “good” companies, by omission, it will also shame the “bad” companies. This is why many have referred to it as the “shame index.” Sony is notably absent from the Nikkei 400 Index, as it posted losses in five of the past six years. And when Toshiba disclosed its multibillion-dollar accounting scandal, it was subsequently removed from the index. The index employs both quantitative and qualitative measures for selecting securities, so there has been some concern that the government may have a say in who gets in and who gets screened out. That said, Japan’s public pension fund, as well as the Bank of Japan, have been large buyers of Nikkei 400 Index funds. Those who want to invest alongside these institutions can do so by purchasing Nikkei 400 ETFs.
A greater emphasis on returns and better corporate governance will be a slow, gradual process, especially in a place like Japan. But if the Nikkei 400 Index helps encourage good, as well as bad, companies to put shareholders first, then, in the long run, all investors should benefit.
